Universal trading licences: Equity exchanges have advantage over commexes

Photo: Reuters
After allowing universal broking licences, the Securities and Exchange Board of India (Sebi) has now allowed setting up of universal exchanges – this means stock exchanges can now enter the commodity turf and commexes can also do stock exchange business like dealing in equity and forex. The market regulator has given exchanges three quarters to prepare for facing competition. However, there does not seem to be a level playing field – commodity exchanges are perhaps on a weaker wicket.

An industry official says: “MCX has better scope to first enter forex derivatives, as forex has a natural extension for commodities. NCDEX will now discuss the possibilities.” On the other hand, BSE and NSE are preparing to launch non-agri derivatives. NCDEX seems less worried as agri is its strong point where other exchanges will not rush to enter.

Several market intermediaries, industry officials and observers suggest that commodity exchanges appear weak, despite their dominance in their respective fields. The reason: Equity markets have evolved over time and have time-tested infrastructure, participants and products, so they have much more diversified revenue streams. But commodity exchanges, among many drawbacks, do not have enough products, they need to further develop market, and they do not have co-location or institutional investors.

The strength of commodity exchanges, especially MCX, is that they have vibrant energy and metals segments, where contracts are cash-settled and prices are derived from global exchanges like the London Metal Exchange for metals and the CME for energy contracts. Since these exchanges are leaders in their respective segments, equity exchanges will find it difficult to get global reference prices for settling their contracts. Sebi has, however, told exchanges to improve physical delivery and “only cash-settled contracts are less preferred by the regulator”, said a source. MCX will also work hard to retain this tie-up before any exchange takes it away.

Even the two major commodity exchanges – MCX and NCDEX – are yet to operationalise their full-fledged clearing corporations. While both plan to do so much before the deadline of September this year, equity exchanges already have clearing corporations that are doing actual settlement work for years. Even after commodity exchanges launch clearing corporations as separate entities, they will have to get the experience.

Stock exchanges also have a co-location facility, which is not permitted for commodities. Sebi is yet to come out with universal exchange norms clearing the air on co-location, among other issues. Assuming co-location will not be permitted for commodities even after all exchanges get the universal exchange status, big investors will go only to existing equity stock exchanges, as they have long established co-lo facilities. “It takes six-nine months to set up and operationalise a new co-location facility. Even if commodity exchanges start trading in equities or currencies, they will be in a disadvantageous situation,” says an industry official.

MCX and BSE permit co-hosting, which means brokers can have their servers nearby but outside the exchange premises -- that is different from co-location. This is permitted because exchanges have no control over brokers setting servers outside the exchange premises.

Commodity exchanges also don’t have indices as a product to trade, while equity exchanges have vibrant index trading, from which they generate revenue, either in trading or by allowing index-based products. Stock exchanges also have income from listing fees, while commexes have yet to develop market, and there is no such assured business. A wide range of income sources allow stock exchanges to fix prices of services when they launch new segments like commodities. “Commodity exchanges will have to first protect their turf and then develop a market, and the degree of predatory pricing by equity exchanges will decide the amount of competition,” says a veteran industry observer. In any case, the competition clock has started ticking for commodity exchanges. 

An industry observer says that there is a scope for equity exchanges to compete with commexes on pricing as commodity transaction charges are on the higher side when compared with equity derivatives. The NSE is said to be aggressive in commodity derivatives, while the BSE has already been working on the commodity derivatives for over a year. The BSE was keen to start gold, silver derivatives where prices are settled by polling domestic prices unlike other metals, and hence deriving settlement price is not an issue for them but now volumes in gold is on a lower side for the past few years.

At present, in the commodity derivatives market, only hedge funds are allowed as institutional investors. Sebi has proposed to also allow mutual funds and portfolio managers in commodities, but it is yet to finalise the norms. Mutual funds are a major support for the equities market at present and are becoming more dominant than foreign investors.

Institutional investors, including banks, remain a major player on equity exchanges. Commodity derivatives lack that benefit. A fund industry representative says: “Hedge funds (alternative investment funds- category-3) are not active as they can only either buy or go short in futures or in plain options but the strategies they can apply are very few as they are not permitted to take arbitrage in spot and futures.”

Even options trading is allowed only in gold on MCX so far, and NCDEX will launch guar seed options this month. This is not enough, market players say. Four-five commodities with the flexibility to apply many more strategies will draw institutional investors. If stock exchanges enter the commodity business, for which they are readying their plans, they will get easier participation from the institutions already associated with equity exchanges.

From the point of view of investors and clients, it does not matter whether an equity exchange broker is giving them the service or a commodity broker, since brokers have been given universal licences.

On the flip side for equity exchanges, while they do have broader revenue sources and support of time-tested infrastructure, apart from institutional players, developing and penetrating the commodities segment – where existing players have generated liquidity – will certainly not be a cake walk.

India and universal exchanges

* India has perhaps as an exception not followed global norms and has permitted universal exchanges. As of now, it is an in-principle decision and terming commodity exchanges as stock exchanges was a first step in that direction.

* India has one regulator for commodities and equities for the past two years. The law recognises all exchanges, whether in commodity derivatives or equities, as stock exchanges. Brokers are given universal licences, which means they don’t have to have a separate company for trading in a commodity and a separate one for equities. In such a scenario, allowing all exchanges to offer all segments is seen as logical.

* The Dubai-based DGCX trade all segments under one roof and these are comparable with India's IFSC-based exchanges, catering to international financial centres. 

* Russia, South Korea and Australia have one exchange to trade in all asset classes but there the share of commodities in total revenues of the exchange is insignificant. 

* The US has separate regulators for equities and another for all derivatives (including in equities, commodities and forex) but exchanges where these commodities are traded are different and equity and commodity are not on any single exchange. 

* Bigger exchanges like the CME and LME are equally giving deliveries of commodities; in India, metals and energy products are cash-settled and settlement prices are derived from those global exchanges.

* The regulator has raised the issue of higher deliveries on derivative commodity exchanges in recent weeks.